China lending rate reform paves path for more banking competition

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China’s decision to remove the floor on bank lending rates is meaningful because it paves the way for further interest rate reforms that in time could increase competition in the banking sector, usher in more flexible exchange rates and open the capital account.

Louis Kuijs, Chief China Economist at RBS
China has long controlled the lending and deposit interest rates that banks can charge and offer, with benchmark rates set by the central bank, the People’s Bank of China. While the government has for a long time had an objective of increasing the role of the market in the financial sector and monetary policy, until recently progress has been modest. Since early last year, the government has taken several steps, with the removal of the floor in late July being a most important one. The decision to remove the floor for the lending rate that banks charge customers underscores the government’s willingness and mandate to advance financial and monetary reform. Some commentators have concluded that the decision does not mean much because the crucial cap on deposit rates was left unchanged, which at the moment is more binding than the lending floor. It is true that the immediate economic impact of the removal is likely to be modest. However, to dismiss the long-term significance of the change would be to overlook the broader economic and political ramifications. 'The lending rate move will focus attention on the obvious next steps in interest rate liberalisation, including the rationale for keeping remaining controls, and makes changes more likely.' The lending rate move will focus attention on the obvious next steps in interest rate liberalisation, including the rationale for keeping remaining controls, and makes changes more likely. So, what are the next steps? First, removing the cap on deposit rates. The thinking has always been that without this cap banks could recklessly bid up the deposit rate to attract deposits, putting themselves and other banks at risk. However, China’s banks have had a lot of time to improve risk management and become more commercially orientated. More competition in the financial sector should lead to more efficient systems and better service. Offering improved deposit rates to savers is also key in rebalancing China’s pattern of growth and levelling the playing field between core banking and shadow banking. In recent years, the shadow banking system, which is made up of financial intermediaries that facilitate the creation of credit but are not necessarily subject to regulatory oversight, has in part been fuelled by low deposit rates and the desire to evade costs associated with controls such as the loan-to-deposit and high-reserve-requirement ratios. As a result, liberalising interest rates and increasing their role in the financial system should help to bring some types of financial activity back into core banking. Second, monetary policy will rely less on quantitative levers and more on interest rates. Presently, quantitative instruments such as credit quotas and loan-to-deposit ratios still effectively control growth of monetary aggregates. However, this creates distortions, with the price of capital often not reflecting its scarcity. Eventually, interest rates should become the key mechanism to transmit monetary policy. Cutting the lending rate floor is also an important step in liberalising China’s exchange rate and capital account policies. In recent months, the government has indicated it wants to step up reforms towards a more flexible exchange rate and a more open capital account. It has already taken some steps towards the latter. Economic logic however calls for making domestic financial reforms on interest rates before fully freeing up the currency and fully opening up the capital account. Finally, lending rate reform may entice some corporates into returning to banks for their borrowing needs, rather than relying on shadow banking. Since early 2012, many companies have turned to the corporate bond market to secure cheaper financing than borrowing at the bank’s 6 per cent lending floor. That, along with financial and monetary policy, now seems likely to change. For more RBS Insight content, click here
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